The Keynesian Theory of Consumption: A Review. Keynes suggested that consumption is a positive function of income, and that high-income households consume a smaller portion of their income than low-income households.

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Inventory Investment

The desired, or optimal, level of inventories is the level of inventory at which the extra cost (in lost sales) from lowering inventories by a small amount is just equal to the extra gain (in interest revenue and decreased storage costs).

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Inventory Investment

There is a trade-off between holding inventories and changing production levels.

Because of adjustment costs, a firm is likely to smooth its production path relative to its sales path. Production should fluctuate less than sales, with changes in inventories absorbing the difference each period.

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Inventory Investment

An unexpected increase in inventories has a negative effect on future production, and an unexpected decrease in inventories has a positive effect on future production.

A firm’s planned production path depends on the level of its expected future sales path.

Future sales expectations are likely to have an important effect on current production.

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A Summary of Firm Behavior

The following factors affect firms’ investment and employment decisions:

the wage rate and the cost of capital.

firms’ expectations of future output.

the amount of excess labor and excess capital on hand.

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A Summary of Firm Behavior

The most important points to remember about the relationship between production, sales, and inventory investment are:

inventory investment (that is, the change in the stock of inventories) equals production minus sales.

an unexpected increase in the stock of inventories has a negative effect on future production.

current production depends on expected future sales.

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Plant and Equipment Investment of the Firm Sector, 1970 I – 2000 II

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Employment in the Firm Sector,1970 I – 2000 II

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Inventory Investment of the Firm Sector and the Inventory/Sales Ratio, 1970 I – 2000 II

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Productivity and the Business Cycle

Productivity, or labor productivity, is defined as output per worker hour (Y/H); the amount of output produced by an average worker in 1 hour.

Productivity tends to rise during expansions and fall during contractions.

During expansions, output rises by a larger percentage than employment, and the ratio of output to workers rises.

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Employment and Outputover the Business Cycle

In general, employment does not fluctuate as much as output over the business cycle.

As a result, measured productivity tends to rise during expansions and decline during contractions.

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Productivity in the Long Run

Theories of (long-run) economic growth focus on productivity, as measured by output per worker, or GDP per capita.

Using productivity figures to diagnose the economy in the short run can be misleading.

The tendency of firms to hold excess labor and capital, and its implications for the measurement of productivity throughout the business cycle, has nothing to do with the economy’s long-run potential to produce output.

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The Relationship BetweenOutput and Unemployment

Okun’s Law is a theory put forth by Arthur Okun, that the unemployment rate decreases about one percentage point for every 3 percent increase in real GDP.

Later research and data have shown that the relationship between output and unemployment is not as stable as Okun’s “law” predicts.

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The Relationship BetweenOutput and Unemployment

There are three “slippages” that combine to make the change in the unemployment rate less than the percentage change in output in the short run:

When output rises by 1 percent, the number of jobs does not tend to rise by 1 percent in the short run.

There are more jobs than there are people employed. Some of the jobs are filled by people who already have one job.

Discouraged workers move back into the labor force.

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The Size of the Multiplier

There are a number of factors we have mentioned that cause the size of the multiplier to decrease. For example:

Automatic stabilizers: When the economy expands and income increases, the amount of taxes collected increases, offsetting some of the expansion.

The interest rate: All else the same, an increase in government spending causes the interest rate to increase, crowding out consumption and investment expenditures.

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The Size of the Multiplier

There are a number of factors we have mentioned that cause the size of the multiplier to decrease. For example:

The response of the price level:Expansionary policy leads to an increase in the price level, which reduces the multiplier, particularly when the economy is on the steep part of the AS curve.

There are excess capital and excess labor: Output can increase by putting excess labor and capital back to work (less investment).

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The Size of the Multiplier

There are a number of factors we have mentioned that cause the size of the multiplier to decrease. For example:

There are inventories: To the extent that firms draw down their inventories in the short run in response to an increase in demand, output does not respond as quickly to demand changes.

The life-cycle story and expectations: The multiplier effects for policy changes perceived to be temporary are smaller.

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The Size of the Multiplier

In practice, the multiplier probably has a value of around 1.4, at its peak. For example, if government spending rises by $1 billion, then GDP rises by about $1.4 billion.

The response of the economy to a change in monetary or fiscal policy is not likely to be large and quick and, in the final analysis, the effects are much smaller than the simple multiplier would lead one to believe.